Friktion — My Robo Hedge Fund
Now I can tell my friends I invest in derivatives
I am a risk-averse farmer and nothing makes me happier than passive income. And now thanks to Friktion, I can flex about investing in “hedge funds”.
What is Friktion?
Cheatsheet for the laywoman (me)
- Solana’s largest automated Defi structured products (mainly options) protocol (or what I am trying to coin as a Robo Hedge Fund).
- In Defi speak, they are a Defi Option Vault (DOV) — where investors deposit their crypto into vaults which is deployed into options strategies.
- Mainnet was launched in December 2021 — yes it became the largest in less than 2 months
- In Jan 2022, it raised U$5.5m from a whole slew of investors. Investors of the round include Jump Crypto, DeFiance Capital, Pillar VC, Libertus Capital, Delphi Ventures, Sino Global Capital, Tribe Capital, Castle Island Ventures, Dialectic, Petrock Capital, Solana Ventures, and others. Pretty good starting network here
- Founders are Alex Wlezien and Uddhav Marwaha. TLDR, they are both really clever guys who were quant traders with backgrounds in math, engineering, and computer science
- Its native strategies for passive farmers like me are called Volts and they employ Covered Calls and Cash Secured Puts. More on this later.
- In the future, they want to be the first Defi protocol to enable investors exposure to volatility and empower them with the ability to hedge impermanent losses too! A true blue Defi Hedge fund..
- What really caught my eye was its institutional product called Circuits— creating separate account mandates for DAOs and other institutions (decentralised automated organisations — basically companies run by code owned by the community working towards a common goal) to run their treasuries. In other words, the DAOs can outsource their treasury management to Friktion, curate their portfolio construction according to their risk appetite. It gets pretty interesting as this will be akin to what is happening in the real world, where institutions form custom separate account mandates with hedge fund managers to deploy into various strategies based on their risks.
Sidenote: This would be a gamechanger as it calls all hedge funds into question — is the Defi model better? In 2021, traditional hedge funds averaged about 10% returns — and Friktion has return profiles that can potentially beat that. I’m excited to see how this pans out over the year.
Why Friktion?
The idea of a Defi hedge fund is so powerful — as this democratizes access into another asset class that is usually only reserved for the rich. So the ability for the layman to gain access to these tools puts everyone on the same playing field.
- Transparency: 1/ What I really liked was their transparent performance reports called Zaps (latest one here) which breaks down their strategy for the week, along with a competitor analysis. It is very very professional — although I wish it could be slightly easier to understand. I had to take some time to break it down for my laywoman's brain (but maybe, that’s just me. Happy to intern with Friktion if they ever need someone to bring it down a notch) 2/ It also helps that they have fully doxxed founders who have been pretty open about strategies and their backgrounds in interviews. 3/ They also just launched a pretty sick analytics platform that will save all of us hours in compiling these stats.
- Sustainable yield: In Defi, yield is usually obtained from staking and providing liquidity — which depends on token emissions and distributions to sustain the yield. This also means that there is an increase in token supply due to these emissions. If the token price drops or collapses, the yield cannot be sustained at the same level. As a DOV — the yield in this case is obtained from option premiums, and therefore “organic” and sustainable.
- Scalability: This is a little complex, but long story short — by using smart contracts, investors deposit their assets into the vault and they are matched with market makers fully collateralized. In traditional finance, according to the smart people at QCP Capital, intermediaries need to get involved to perform a liquidation mechanism . But if option contracts are fully collateralised, there is no need for liquidation. In simple words, it removes that step of the process, enabling greater scalability.
How does it work?
Btw, I scored an A in Derivatives during college and sat for 2 CFA exams — so I should be able to explain this.
Epochs (Weekly auction cycles)
Basically you can deploy your crypto into any vaults from Monday to Friday morning 8am UTC — but they will only get deployed every Friday 8am and lasts a week till the next Friday. An Epoch simply means the cycle where the vaults go through an auction process where market makers bid for the options created by the vault.
Investment strategies
1/ Covered Call
- Holding an asset, say a banana you got for $8 and selling a call option. The call option is a contract that says you are obligated to sell the banana to your friend Ben at the strike price say $10.
- In exchange for selling the option, Ben pays you an option premium, say $2.
- When the banana price increases to ≥ strike price, that’s when the option will be exercised, as Ben will want to buy the banana from you at a price cheaper than the market, so he can immediately sell the banana on the open market for profit. So let’s say the banana becomes $15, you still have no choice but to sell it to him for $10.
- Profit: call option premium + strike price — price you paid for your asset = $2 + $10 — $8 = $4
As an opportunity to show off my finance degree, I created an easy calculator to exemplify this using SOL (Solana’s native coin):
1/ Your upside will always be capped at 15% even if SOL hits the moon. (you are obligated to deliver your SOL at $110 (a $10 capital gain) along with the $5 you earned from selling the option to Ben. ) Ben on the other hand, just became a millionaire.
2/ You still have the downside of your SOL falling, but partially offset by the $5 premium.
3/ This strategy works best if the market trades sideways (scenario 3), you will always get the 5% return on investment.
2/ Cash Secured Put
- You put up cash as collateral against the banana (now worth $15) and sell a Put option on the banana to Ben, with a strike price of $12. You can assume Ben has the banana, as you just sold it to him above.
- In exchange for selling the option, Ben pays you an option premium $2.
- When the banana prices falls ≤ strike price, that’s when the option will be exercised, as Ben will want to sell the asset to you at a price higher than the market. So let’s say the banana falls back to $8 — Ben then exercises the option so I can buy the banana from him at $12 even though its worth $8.
- Position: put option premium + current banana price + remaining cash = $2+ $8 + ($15 — $12) = $13
- Profit = $13 — $15= (— $2)
Again, to continue flexing about my finance degree:
1/ Your upside will always be capped at your option premium. So there’s a lot of opportunity cost if we are in a bull market. In scenario 2, if you bought SOL instead of going into this strategy, you would have made a 20% return instead of 5.
2/ You still have the downside of SOL falling, but partially offset by the $5 premium. In Friktion, even if the option is exercised and you are assigned SOL, you don’t get to keep SOL as Friktion will automatically re-balance it back to cash (stablecoins).
3/ This strategy works best if the market trades neutral or slightly bullish (scenario 3), you will always get the 5% return on investment.
Key Takeaways
1/ Managing expections: Options are complex, and I feel that not every investor understands the opportunity costs involved . Investors may come in simply for the juicy APYs of close to 40% — and not fully understand their risks, which I believe can always be made clearer when marketing such investment strategies. In a super bullish market, you would stand to gain a lot more by simply holding the asset. In my very humble opinion, these option strategies work best when the market is relatively “neutral” and volatile (trading sideways). So, if you are looking to 100x your coin in the short term, this strategy may not be for you. In my case, since I am a farmer, I am using it as a means to generate passive income while the market is volatile. (FYI — Option premiums increase with market volatility. See, I remember the Black Scholes pricing model)
2/ Growth Potential: What I really liked about Friktion was its immense growth it has seen in a mere 2 months, and its growth potential ahead. 1/ Firstly, they have a really impressive, professional UI that looked and felt great to use. 2/ Diving into their discord, there are new announcements pretty much every few days — their analytics platform being one of the latest. (PS — this looks exactly like what a hedge fund dashboard/factsheet looks like! Impressed.) 3/ I am also very excited to see how Circuits grows along with the astronomic growth in DAOs — it may be a cheaper, more effective way for DAOs to outsource their treasury management rather than employ a treasury manager, who you know, may be a criminal (hint). So far they have 1 institutional client InvictusDAO — in which they can use as a case study to showcase track record and returns. I could definitely see its growth exploding when they onboard more DAOs.
4/Opportunities for more liquidity seem imminent as we have the option to mint a VoltToken when you deploy your crypto into the Volts that represents your ownership in the Volt. I could see how this could be used as collateral or staked in other protocols in the near future.
3/ The Future: Friktion is a key player in the Defi Options Vaults (DOV) landscape (other big players being Ribbon Finance (first mover, Ethereum), StakeDao)— and for now we only see plain vanilla strategies such as the Covered Call and Cash Secured Puts mostly. So its just the beginning.
Beyond the investor’s perspective, options play a key role in the financial ecosystem for hedging, providing liquidity, forming other complex derivative structures. The basic strategies form the proof-of-concept and blueprint for more products and strategies to be created. And guess what — everyone can be a part of it.
We’re coming for you, Suits.
Resources
- Options Vaults — The Next DeFi Lego Block : good read about the Defi Options ecosystem
- An Explanation of DeFi Options Vaults (DOVs) : good read about wht DOVs are from QCP Capital (a digital asset trading firm from Singapore)
- A Quantitative Analysis of DeFi Option Vault Strategies: Smart guy who backtested covered call strategies on ETH and SOL and proved that the opportunity cost can be huge.
I am using Friktion and this is not financial advice. If you noticed, I didn’t complete my CFA — otherwise, I would be AnonFemale, CFA.
